The use of emissions trading in relation to other means of reducing emissions : A Nordic comparative study

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TemaNord 2006:539

The use of emissions trading

in relation to other means of

reducing emissions

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Nordic Environmental Co-operation

The Nordic Environmental Action Plan 2005-2008 forms the framework for the Nordic countries’ environmental co-operation both within the Nordic region and in relation to the adjacent areas, the Arctic, the EU and other international forums. The programme aims for results that will consolidate the position of the Nordic region as the leader in the environmental field. One of the overall goals is to create a healthier living environment for the Nordic people.

The Nordic Co-operation on Economy and Finance

Nordic co-operation in the area of economy and finance includes consultations on stabilisation policies, studies and discussion of strategies for structural policies, evaluation of adjustment policies for the European economic integration process as well as support to the economic transformation process in Eastern- and Central Europe. The work in this area is governed by the Ministers of Fi-nance and Economy and they are assisted by a Nordic Committee of Senior Government Officials. Nordic co-operation

Nordic co-operation, one of the oldest and most wide-ranging regional partnerships in the world, involves Denmark, Finland, Iceland, Norway, Sweden, the Faroe Islands, Greenland and Åland. Co-operation reinforces the sense of Nordic community while respecting national differences and simi-larities, makes it possible to uphold Nordic interests in the world at large and promotes positive relations between neighbouring peoples.

Co-operation was formalised in 1952 when the Nordic Council was set up as a forum for parlia-mentarians and governments. The Helsinki Treaty of 1962 has formed the framework for Nordic partnership ever since. The Nordic Council of Ministers was set up in 1971 as the formal forum for co-operation between the governments of the Nordic countries and the political leadership of the autonomous areas, i.e. the Faroe Islands, Greenland and Åland.

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Table of Contents

Preface... 7

Summary ... 9

1. Introduction ... 17

1.1 Background... 17

1.2 Contents of the report ... 19

2. Emission targets, levels and projections ... 21

2.1 Emission targets... 21

2.2 Historic and current emission levels ... 23

2.3 Projected future emissions ... 28

3. ETS combined with other instruments – theoretical issues... 31

3.1 Introduction... 31

3.2 The effects of using multiple instruments ... 31

3.2.1 Emissions trading and emission taxes... 32

3.2.2 Emissions trading, subsidies, green certificates and regulations... 35

3.3 Conclusions ... 37

4. Effects from ETS and other instruments – quantitative studies ... 39

4.1 Aggregated economic effects of the EU ETS ... 40

4.2 Effects on competitiveness ... 45

4.3 EU ETS and other instruments... 50

4.4 Effects on non-trading sectors... 52

4.5 Summary and conclusions ... 54

5. The introduction of emissions trading ... 57

5.1 Emissions trading 2005–2007... 57

5.1.1 Features of emissions trading in the Nordic countries ... 57

5.1.2 The market development so far... 63

5.2 Emissions trading in 2008–2012... 66

5.2.1 Changes in the EU ETS framework... 66

5.2.2 EU ETS in relation to the Kyoto mechanisms ... 68

6. Other instruments and strategies 2008–2012 ... 73

6.1 Current instruments... 73

6.2 Changes due to emissions trading... 79

6.3 The balance between emissions trading and other instruments... 80

6.4 The Nordic countries’ climate strategies in 2008–2012... 84

7. Concluding discussion... 97

References ... 101

Sammanfattning... 105

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Preface

The Environment and Finance Working Group and the Climate Change Policy Working Group of the Nordic Council of Ministers, has commis-sioned ECON Analysis to prepare this report “The use of emissions trad-ing in relation to other means of reductrad-ing emissions - a Nordic compara-tive study”.

The Environment and Finance Working Group and the Climate Change Policy Working Group does not necessarily share the views and conclusions of the report, but looks at is as a contribution to our knowl-edge about the emissions trading in relation to other means of reducing emissions of greenhouse gasses.

Oslo, May 2006 Copenhagen, May 2006 Jon D. Engebretsen Jørgen Schou

Chairman Chairman

Climate Change Policy Environment and Finance

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Summary

Abstract

This study analyzes how the Nordic countries have dealt with or plan to deal with the conditions of the EU emissions trading system (EU ETS) and the relation to other measures to curb emissions. Concerning the use of emissions trading and other instruments, there are a lot of similarities among the Nordic countries, but also some fundamental differences. Given the information available so far, Denmark and Finland will make extensive use of the EU ETS and government purchase of credits through the Kyoto mechanisms to reach their commitments in the period 2008– 2012. Norway anticipates that the emissions reductions attained through domestic policies and measures will not be sufficiently large to reach the Kyoto commitment and the use of the flexible mechanisms will hence be an important part of the strategy. However, the division between the use of emissions trading and government purchase of credits through the Kyoto mechanisms is not yet decided. Sweden’s use of emissions trading is still not decided, but the current national emission target does not in-clude emission reductions using the flexible mechanisms. Iceland, finally, will not take part in the EU ETS in the period 2008–2012. So far, the introduction of the ETS has led to relatively small adjustments of existing instruments in the Nordic countries. Thus, many instruments are still used in parallel with the ETS. In the study we conclude that the large number of energy and climate policy instruments that are used in the Nordic countries may interact in a suboptimal way. This suggests that the mar-ginal incentive to reduce greenhouse gases provided by each instrument should be assessed in a systematic economic analysis of all climate poli-cies in use.

Background

All Nordic countries have ratified the Kyoto Protocol, and therefore have binding commitments to reduce their greenhouse gas (GHG) emissions to the period 2008–2012. The Nordic countries also have a tradition of rela-tively tough environmental policy. For quite a long time they have had explicitly formulated climate change strategies and have used various measures intended to curb emissions.

Since 1 January 2005 an emissions trading scheme is in operation within the European Union (“the EU ETS”), after several years of prepa-ration. As members of the union, Denmark, Finland and Sweden were obliged to implement the EU ETS. Norway has developed a domestic emissions trading scheme, which shadows, and most likely will be

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con-nected to, the EU ETS. Iceland neither takes part in the EU ETS nor has a national emissions trading scheme.

The EU ETS does not cover all sectors of society. At present, it is con-fined solely to CO2 emissions from installations in heat and power

pro-duction and in energy-intensive industry. When setting climate policies the Nordic countries must take this in to account, and try and find the right balance between emissions trading and other means of reducing emissions. In view of this, the Nordic Council of Ministers has commis-sioned ECON, in co-operation with Electrowatt-Ekono of Finland, to conduct a comparative study of how the Nordic countries intend to make emissions trading work together with existing climate strategies.

Problem statement

This study analyzes how the Nordic countries intend to make emissions trading work together with other climate policy instruments. The study has comprised of two parts. The first part contained a comparative analy-sis of some aspects of how the Nordic countries have dealt with the con-ditions of the EU ETS in the present period, 2005–2007, and the relation to other measures to curb emissions. The second part of the study has been focused on implications of the EU ETS for the Nordic countries in 2008–2012. This report contains the results of the study’s both phases.

In accordance with the assignment from the Nordic Council of Minis-ters, the study has put special emphasis on economical effects. The main focus for the study has been the following question:

In what way have other climate policy instruments, and the Nordic countries’ climate strategies in general, been affected by the introduction of emissions trading?

The study’s main findings

The Nordic countries’ use of instruments other than emissions trading is in many ways similar…

In some ways the prerequisites for carrying out climate change poli-cies differ between the Nordic countries. For instance, due to varying industrial and energy production structures, the size of total emissions vary between the countries. Furthermore, the Nordic countries’ interna-tional emission reduction commitments, and the challenges it will mean to reach them, vary quite a lot, with the extremes being Iceland and Den-mark. Thus, Iceland can allow for an increase in current emission levels of more than 10 percent to the commitment period (2008–2012) and still reach its target, whereas Denmark needs to cut its emissions by approxi-mately 20 percent to be able to reach its target.

Still, there are a lot of similarities in the way the Nordic countries have chosen to battle climate change. Thus, albeit the application of dif-ferent measures may vary, by and large the Nordic countries use the same

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The use of emissions trading in relation to other means of reducing emissions 11

kind of policy instruments in order to reduce GHG emissions, for in-stance:

• Carbon dioxide taxes. All Nordic countries except Iceland use a CO2

tax. Generally, the tax is levied on the use of fossil fuels in relation to their carbon contents. However, there are differences in how the tax is imposed, e.g. a number of different exemptions are used.

• Energy related taxes. All Nordic countries use energy related taxes, but the tax design differs between countries. The purpose of the energy related taxes are primarily fiscal. But the taxes also have an effect on energy consumption and on CO2 emissions.

• Long-term, voluntary agreements. Some sort of voluntary agreements between industry and the government are used in all Nordic countries. These agreements typically mean that the concerned industry, for instance, gets a reduction of the CO2 tax rate and in exchange has to

carry out energy saving investments.

• Subsidies and green certificate systems. Subsidies to renewable energy production and energy conservation are used in all Nordic countries except Iceland. Of the Nordic countries, Sweden is so far the only one that has introduced a system of green certificates, but other Nordic countries are considering doing so.

• Use of JI and CDM. Denmark and Finland has announced that they intend to use credits from Joint Implementation (JI) and the Clean Development Mechanism (CDM) in order to fulfil their Kyoto

commitments. Norway has indicated that the mechanisms will be used if necessary. Sweden has a programme for JI and CDM, but has not yet decided in what way the credits will be used.

…and so is the implementation of emissions trading in the Nordic countries 2005–2007

Except for Iceland, all Nordic countries have introduced emissions trad-ing for the period 2005–2007. There are, for natural reasons, strong simi-larities in the implementation among the Nordic EU Member States. The Norwegian implementation differs somewhat, mostly due to a substan-tially lower coverage. The main elements of the implementations are summarized in table A below. Information about Norway refers to the national ETS, which will probably be connected to the EU ETS.

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Table A Main elements in the introduction of emissions trading in the Nordic countries 2005–2007

Denmark Finland Norway Sweden

Trading sector’s share of emissions¹ 60 % of CO2 emissions, 47 % of all GHG emissions 71 % of CO2 emissions, 60 % of all GHG emissions 16 % of CO2 emis-sions, 13 % of all GHG emissions 42 % of CO2 emis-sions, 33 % of all GHG emissions Number of installations (approx.) 350 550 50 700

Total allocation, yearly average 2005–2007

33.5 million tonnes 45.5 million tonnes 6.8 million tones 22.9 million tonnes

Allocation compared to recent emissions

Power and heat production: 96 % of 2002 emissions Others: 110 % of 2002 emissions

Power and heat production: 105 % of average emis-sions 1998–2002 / 2000–2003 Others: 119 % of average emissions 1998–2002

Power and heat production: 95 % of average emissions 1998–2001 Others: 95 % of average emissions 1998–2001

Power and heat production: 80 % of average emissions 1998–2001 Others: 100 % of average emissions 1998–2001. 100 % of projected process emissions.

Auctioning Yes, 5 % of total allocation

No No No

Opt-in/Opt-out No/No Yes/No No/”Yes”² Yes/No

Allocation method for existing installations (base years) Grandfathering (1998–2002) Grandfathering (1998–2002 on general, but 2000– 2003 for conden-sate power plants)

Grandfathering (1998–2001) or expected emissions

Grandfathering (1998–2001)

Allocation method for new entrants

Benchmarking Benchmarking Based on ex-pected CO2 emissions

Benchmarking

Notes: ¹) The share is calculated as ‘Total allocation, yearly average 2005–2007’ in relation to the yearly average for total

emissions in the years 1999–2003 (as shown in table 2.2). ²) Norway has chosen a trading regime in which emissions from burning of fossil fuels that are subject to CO2 tax is exempted from the regime. This could perhaps be described as an

“opt-out”, and is the main reason why the Norwegian ETS is of relatively limited scope.

Changes in climate policy instruments due to emissions trading so far are only marginal…

How the Nordic countries’ climate strategies will finally be affected by the introduction of emissions trading is really too early to say, since the climate strategies presently are under revision in many of the countries. Thus, Finland (late 2005) and Sweden (March 2006) have recently pre-sented new, or at least revised, climate strategies, while Iceland will probably do so later this year. One of the circumstances that have brought about the need for revision is the introduction of emissions trading.

So far, the introduction of emissions trading seems to have led to rela-tively marginal corrections of the former climate strategies. In the EU Member States Denmark, Finland and Sweden the EU ETS seems hith-erto to have been mainly implemented alongside existing policy instru-ments and to have led to only minor corrections of existing instruinstru-ments. To some extent this seems to be true also of Norway. But since Norway is not an EU Member State, it could choose a somewhat different approach

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The use of emissions trading in relation to other means of reducing emissions 13

in the introduction of emissions trading. Thus, Norway uses emissions trading as a complement to CO2 taxation, by excluding CO2 taxed

emis-sions from the ETS.

The main changes in other climate related measures due to the intro-duction of emissions trading that so far has occurred, can be summarized in the following fashion:

• Denmark: The national emissions trading system that for some years had been in operation in order to curb carbon dioxide emissions from electricity production was abolished in 2005, due to the obvious overlapping with the EU ETS.

• Finland has introduced a CO2 tax relief on heat production with peat

and removal of subsidies for electricity generation with peat. The main reason for these changes was to compensate for the loss of competitiveness against other fuels caused by the introduction of the EU ETS.

• Norway: There are emissions from several industries (i.e. process emissions from aluminium etc.) that neither are covered by the EU emissions trading directive, nor by the Norwegian CO2 tax. The

Norwegian government decided that some policy instruments should be directed towards these emissions as well. Therefore a new

agreement on emissions reductions was signed between these industries and the authorities.

• Sweden: Some changes have been made in the environmental legislation. Thus, the requirements in the Environmental Code concerning restrictions on emissions of carbon dioxide and on the quantity of fossil fuel used have been removed for plants covered by the EU ETS.

…but further changes are proposed

According to theoretical studies and numerous quantitative assessments the interaction between energy and climate policy instruments is often complex. Hence, different measures can act together in a counterproduc-tive way, thus increasing the overall cost of reaching the goal. The case where CO2 emissions trading is used with CO2 taxation on the same

emit-ter is an apparent example where multiple instruments might hinder a cost effective outcome.

Based on the cost efficiency aspiration declared in the climate strate-gies, one should expect the Nordic countries to make some adjustments of pre-existing policy instruments. There are now clear indications that steps are taken in that direction. For example, both Sweden and Denmark are in the process of reducing the emission trading industries’ CO2 tax

burden, and Finland will lower the electricity tax on industry within the ETS. However, other climate policy related instruments applied on the trading sectors, such as green certificates systems and subsidies, are still

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used in parallel with the ETS. This could interfere with the cost effective-ness of the emissions trading system. One should however bear in mind that some of these instruments, like the green certificate system, have other policy objectives.

Balancing the use of ETS and other instruments involves uncertainty and complex decisions

Due to the partial sectoral coverage of the EU ETS there is a problem of “balancing” emissions trading with the use of instruments in the non-trading sector to achieve the Kyoto commitment. The chosen balance will have implications for the cost of reaching the emission target. However, many variables that are important for the decision are still highly uncer-tain. Central variables are e.g. the cost of further emissions reductions in the non-trading sector, i.e. mainly emissions from transport and heating; the price of credits from JI and CDM projects (and the cost of raising public funds to purchase programs); and the future price of allowances within the EU ETS.

So far, there have only been indications on how the countries will handle this “national burden sharing” in the period 2008–2012. Denmark, Finland and Norway anticipate that the future emission reductions in the non-trading part of the economy will not be sufficient to attain the emis-sion target. These countries therefore see the flexible mechanisms as an important part of their policies. In the case of Norway, however, it should be noted that the size of the non-trading part of the economy is still un-certain and an expansion of the current limited sectoral coverage may be proposed. Sweden, on the other hand, has an indicative emissions target for the transport sector which specifies that large emissions reductions ought to be achieved in this sector.

Table B summarizes the Nordic countries chosen policy balance based on the information available so far.

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Table B The Nordic countries planned use of EU ETS and other instruments 2008–2012

Denmark Finland Norway Sweden

Kyoto gap 17.3 Mt CO2 eq. per year1 11 Mt CO2 eq. per year 11 Mt CO2 eq. per year -0.7 Mt CO2 eq. per year (but 2.1 Mt above current

national target)

EU ETS Not yet decided. (No explicit restric-tion on use of JI/CDM credits indicated in national implementation of the Linking directive.)

Not yet decided. (Estimated 5.9 Mt reductions per year used in latest “with measures” projections.)

Not yet decided. (Low coverage of current domestic system reduces the possible use. Discussions on including e.g. the offshore petroleum activities, which would increase the possible use of the ETS.)

Not yet decided. (Allocation proposed to be based on the current national target. Proposed restrictions on the use of JI and CDM credits within the ETS. The ETS could not be used toward the current national target.)

Government use of the Kyoto mecha-nisms

The government will buy approx. 4.5 Mt per year.

The government plans to buy approx. 2.4 Mt per year

Not yet decided but it is foreseen that the gov-ernment will acquire Kyoto units if necessary to fulfil the commitment

Approx. 1 Mt per year through pilot programs. (Not yet decided how these credits will be used. Could not be used toward the current national target.)

Domestic policies and measures

Largely under investiga-tion. (No overall tax increase but possi-bly tax differentiation. Subsidies to renewable energy. Energy labeling of buildings.)

Approx. 1 Mt per year in total estimated. (Energy conservation important. Attained largely through agreements, energy audits and other energy conservation programmes. Transport related measures will reduce approx. 0.5 Mt per year.)

Small future reductions estimated. (CO2 tax and

voluntary agreements with industry. CO2 tax on

transports is the main instrument to limit emis-sions. Proposed increase in the tax rate on domestic aviation, domestic shipping of goods and supply ship. Targets on each sectors contri-bution will be presented.)

Should be used to fulfil the national target, 2.1 Mt per year.

(Large number of measures used and proposed. No estimate of effects provided. Indicative (strict) sector specific target concerning the emissions of CO2 from

transports. Increased use of renewables by using green certificates. )

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Given the uncertainty concerning the price of emission allowances, the cost to the economies from far-reaching use of the EU ETS is still highly unsure. It is also very much dependent on the policy balance chosen by other European countries. A number of quantitative assessments point toward potentially large direct and indirect effects on some of the trading sectors’ international competitiveness. This indicates that, at least in the longer run, costly structural changes may be brought about. At the same time, other studies indicate that further emission reductions through poli-cies and measures on non-trading sectors may be costly.

In general, participants in the EU ETS call for stable and foreseeable conditions. However, due to the prevailing uncertainty in several dimen-sions and the dependence on other countries’ choices, decidimen-sions concern-ing the policy balance are difficult to make and for the time beconcern-ing it may even be valuable to postpone decisions.

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1. Introduction

1.1 Background

The Nordic countries have a tradition of relatively tough environmental policy. For quite a long time they have also had explicitly formulated climate change strategies and have used various measures intended to curb emissions, e.g. Denmark, Finland, Norway and Sweden all intro-duced a carbon dioxide tax on fossil fuel consumption in the early 1990’s.

In recent years, however, the conditions for setting climate policies have been transformed to a certain extent, since on 1 January 2005, a scheme for trading in emission allowances (“emissions trading”) was introduced in the EU. In the implementation of this scheme in the Nordic countries, the question of how to make it work together with existing climate strategies has been of great importance.

The EU Emissions Trading Scheme (EU ETS) is based on a directive that was formally adopted in October 2003.1 The EU ETS comprises various time periods. The first period (2005–2007) is partly intended as a learning experience. The following periods will run in five-year cycles, i.e. 2008–2012, 2013–2017 etc.

Emissions trading is a market-based instrument of climate policy, which is commonly regarded as the most cost-effective and economically efficient way of reducing emissions. The EU ETS does, however, possess some characteristics that separate it from a theoretically ideal emissions trading scheme, for example:

• The EU ETS does not cover all sectors of society. In the first period (2005–2007), it is confined solely to CO2 emissions from installations

in energy-intensive industry (production and processing of ferrous metals, minerals, and paper, paperboard and pulp) and combustion units with capacity above a certain level (20 MW) in heat and power production. In the whole EU, the system covers roughly 12 000 installations. The European Commission has estimated that the scheme will cover approximately 46 percent of the projected EU CO2

emissions in 2010.

• The majority of the emission allowances are not allocated through auctioning in the EU ETS. Thus, the directive states that EU Member States are to allocate at least 95 percent of the emission allowances

1 Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003

estab-lishing a scheme for greenhouse gas emission allowance trading within the Community and amend-ing Council Directive 96/61/EC (OJ No. L 275, Volume 46, 25 October 2003).

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free of charge during the three-year period 2005−2007. For the first commitment period, 2008−2012, at least 90 percent are to be distributed free of charge.

• The principles for allocating emission allowances free of charge for the period 2008–2012 have not been clearly specified yet, at least not in detail. This creates an element of uncertainty for the carbon market in the present period.

• Other climate policy instruments have on general not been subject to European harmonization.

The overall conditions for the EU ETS in the period 2008–2012 are to a large extent given by the directive. However, some adjustments in the trading scheme for the period 2008–2012 will most likely be realized during 2006. Thus, in the first part of 2006 the European Commission will work out a proposal for changes in the EU ETS for the period 2008– 2012. The proposal shall then be negotiated between the Member States and approved during 2006. At present, it can be anticipated that the nego-tiations only will lead to relatively minor changes, e.g. the trading scheme will probably not be amended with more greenhouse gases or sectors (with the possible exception of aviation) already in 2008.

Subject for the study

The design and implementation of the EU ETS raises some questions of special interest to the Nordic countries that take part in the scheme. One such aspect is that the Nordic countries use other greenhouse gas related measures to a larger extent than most other European countries, which could have implications for the effectiveness of the trading scheme. In addition to effectiveness issues, possible elimination, or at least reduced use of other measures, e.g. CO2 taxes, for sectors covered by the ETS

could also have fiscal consequences. Furthermore, Sweden has intro-duced (and other Nordic countries are considering doing so) a system of green certificates in order to increase the amount of power production based on renewable sources. This also affects the conditions for setting and obtaining climate change targets. The existence of a common Nordic power market also gives cause for a special Nordic perspective on the EU ETS.

In view of the forthcoming negotiations on the conditions of the EU ETS for 2008–2012, and the somewhat special conditions for implement-ing the EU ETS in the Nordic countries, the Nordic Council of Ministers has commissioned ECON, in co-operation with Electrowatt-Ekono of Finland, to conduct a study of how the Nordic countries intend to make emissions trading work together with other climate policy instruments. The study is to put special emphasis on economical effects

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The use of emissions trading in relation to other means of reducing emissions 19

• In what way have other climate policy instruments, and the Nordic countries’ climate strategies in general, been affected by the introduction of emissions trading?

In accordance with the assignment from the Nordic Council of Ministers, the study has been carried out in two phases. The first phase comprised of a comparative analysis of some aspects of how the Nordic countries have dealt with the conditions of the EU ETS in the present period, 2005– 2007, and the relation to other measures to curb emissions. The prelimi-nary results of the first phase were presented to and discussed with the Nordic Council of Ministers in September 2005. The second phase of the study has focused on implications of the EU ETS for the Nordic countries in 2008–2012.

Since the report deals with the relation between emissions trading and other instruments, it is mainly focused on Denmark, Finland, Sweden (as they are EU Member States) and Norway (which has a national emissions trading scheme that will most likely be connected to the EU ETS). Thus, Iceland, which neither takes part in the EU ETS nor has a national emis-sions trading scheme, is generally left out of the discussion. Iceland is, however, included when we discuss climate targets and emission levels more in general (see chapter 2).

The sources that have been used for the study consist, to a large ex-tent, of various official documents (e.g. the Nordic countries’ climate strategies, National Allocation Plans, and National Communications un-der the UNFCCC), but also of other sorts of background material; see the enclosed list of references.

The report has been written by ECON. The information about Finland, and vital comments on the report, has mainly been provided by Electro-watt-Ekono.

1.2 Contents of the report

Although the work of the study has been carried out in two phases, this report, which contains the results of the study’s both phases, is not struc-tured strictly in accordance with the two phases. Instead, in order to better reflect the main question of the study, we have chosen a more thematic presentation. Thus, after an overview of the Nordic countries’ emission targets, levels and projections is given in Chapter 2, we deal with the question of in what way other climate policy instruments, and the Nordic countries’ climate strategies in general, have been affected by the intro-duction of emissions trading in the following fashion:

First, we discuss how, from a theoretical viewpoint, the introduction of emissions trading could be affected by other climate policy instru-ments and the Nordic countries’ climate strategies in general. Thus, in

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Chapter 3 we discuss emissions trading in combination with other

in-struments from a more theoretical standpoint. Then, in Chapter 4, we analyze results from various model based quantitative assessments (some general, but mainly studies concerning the Nordic countries) of the ef-fects from the introduction of emissions trading. All of these studies were done before the EU ETS had actually started. In fact, several of the stud-ies were carried out directly in connection with governmental ex ante investigations of how the EU ETS should be implemented.

Secondly, we discuss how, in practice, the introduction of emissions trading so far seems to have affected other climate policy instruments and the Nordic countries’ climate strategies in general. Thus, in Chapter 5 we discuss the introduction of emissions trading in the Nordic countries. We present the main features of emissions trading in the period 2005–2007, the development so far, and discuss how the conditions might change in the period 2008–2012. Then, Chapter 6 contains a comparative analysis of the use of instruments other than emissions trading in the Nordic coun-tries’. In chapter 6, we also analyze to what extent these instruments have been affected by the introduction of emissions trading, and the outlook of the Nordic countries’ climate strategies for the period 2008–2012.

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2. Emission targets, levels and

projections

All Nordic countries have ratified the Kyoto Protocol. This implies that all countries have a binding greenhouse gas (GHG) emission reduction commitment for the period 2008–2012.

In order to describe the challenges the Nordic countries will meet in trying to fulfil their Kyoto commitments, we in this chapter give a brief overview of the Nordic countries’ emission targets (2.1), their historic and current emission levels (2.2), and their projected future emissions (2.3).

2.1 Emission targets

All Nordic countries except Sweden have a national emission target that corresponds to their commitment according to the Kyoto Protocol. Swe-den, on the other hand, has adopted a stricter emission target in its na-tional climate strategy.

A country’s emission reduction commitment according to the Kyoto Protocol refers to the period 2008–2012 and is set in relation to the coun-try’s 1990 emissions – this is also the way that Sweden’s national target is set. The Nordic countries’ emission targets, in relation to emissions in 1990, are shown in table 2.1 together with emissions for the years 1990 and, which is the latest available statistics for all countries, 2003.

As is shown in table 2.1, the countries’ emission targets vary quite a lot. Some countries need to make substantial reductions compared to their 1990 emissions, while others even can increase their emissions. For com-parisons sake, it should be mentioned that total EU15 emissions need to be reduced by approximately 5 percent from the current level, if the com-bined EU15 target under the Kyoto Protocol of an 8 percent reduction is to be reached.

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Table 2.1 The Nordic countries’ emission targets GHG emissions 1990 (million tonnes CO2 equivalents) Target for 2008–2012 (in % relative to 1990) Target for 2008–2012 (calculated as million tonnes CO2 equivalents) GHG emissions 2003 (million tonnes CO2 equivalents) Denmark 69.3 -21 % 54.7 73.9 Finland 70.5 0 % 70.5 85.6 Iceland 3.3 +10 % 3.6 3.1 Norway 50.1 +1 % 50.6 54.8 Sweden 72.2 -4 % 69.3 70.6

Some explanatory comments about the emissions targets need to be made about Denmark, Iceland and Sweden:

• Denmark. According to the EU burden sharing agreement, Denmark’s commitment for the period 2008–2012 corresponds to annual

emissions of just below 55 million tonnes. However, a final decision on what the Danish commitment will mean in terms of tonnes has not yet been made. Denmark’s emissions were unusually low in 1990, since Danish power plants produced less than usual due to large electricity imports from Norway and Sweden, made possible by heavy rainfall. Denmark has argued that the country should be compensated for this. If the EU agrees (it will be decided in 2006), Denmark will be allowed to emit just under 60 million tonnes CO2 equivalents annually

from 2008–2012.

• Iceland. The Icelandic obligations according to the Kyoto Protocol are two fold. First of all, as is shown in table 2.1, the greenhouse gas emissions shall not increase more than 10 percent from the level of emissions in 1990. However, as a relatively small economy in which individual sources of industrial process emissions can have a

significant proportional impact on emissions at the national level, Iceland has also in one respect been awarded special status in the Kyoto Protocol. Thus, in line with Decision 14/CP.7, additional emissions of up to 1.6 million tonnes originating from large single projects initiated after 1990 shall be reported separately and carbon dioxide emissions from them not included in national totals. In Iceland’s case, these conditions mainly concerns abrupt increases in emissions from aluminium production associated with the possible expansion of production capacity of this industry.

• Sweden. According to the EU burden sharing agreement, Sweden’s emissions of the Kyoto Protocol’s greenhouse gases are to be limited to 104 percent compared to the 1990 level in the first commitment period. However, according to a decision by the Swedish Parliament in 20022, Swedish emissions of greenhouse gases for the period 2008– 2012 are to be at least four percent lower than emissions in 1990.

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The use of emissions trading in relation to other means of reducing emissions 23

According to the national target, emissions during this period shall at most correspond to 96 percent of emissions in 1990 without

compensation for absorption in carbon sinks or by flexible mechanisms. In its proposal for a revised climate strategy, the

Swedish government has recently stated that the target for 2008–2012 shall remain as was decided in 2002.3 Complementing this, a more long-time target is also introduced. Thus, the government proposes that the emissions for Sweden in 2020 should be 25 percent lower than in 1990. Through a set of checkpoints every five years, starting 2008, the development will be continuously reviewed.

It must be emphasized that the Kyoto commitments relate to 2008–2012, and that none of the Nordic countries have an explicit emission target for the period 2005–2007. Furthermore, it is not possible to give a certain prediction of whether the countries will reach their targets or not, solely by observing past and current emission levels and the target for 2008– 2012. The optimal path depends on, among other things, the country’s industrial structure and could therefore differ between the Nordic coun-tries.4 It is therefore not un-complicated to identify if the countries are progressing optimally toward the target and how large the emissions should be in the period 2005–2007. Still, the differing sizes of the gap between current emission levels and the Kyoto target at least indicates that the Nordic countries’ efforts to meet their Kyoto commitments in the coming years will be of varying difficulty.

2.2 Historic and current emission levels

How the Nordic countries’ GHG emissions in total have evolved since 1990 is shown in table 2.2 below. Since the EU ETS at present only in-cludes CO2, the table also shows the evolvement of CO2 emissions.

3 Prop. 2005/06:172.

4 If, for example, the policymaker wish to avoid large premature retirement of the current capital

stock it could be optimal to postpone abatement. See e.g. Grubb (1997) for a discussion on economic issues of the timing of abatement.

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Table 2.2 Evolvement of total GHG emissions (in million tonnes CO2 equivalents) and

of carbon dioxide emissions (in million tonnes) in the Nordic countries

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Denmark -Total GHG 69.3 80.0 73.8 76.2 79.7 76.7 90.0 80.3 76.1 72.9 68.3 69.7 69.0 73..9 -CO2 52.9 63.6 57.8 60.1 63.7 60.6 74.0 64.5 60.4 57.5 53.1 54.6 54.3 59.2 Finland -Total GHG 70.5 69.5 66.8 67.9 74.4 71.6 76.9 76.0 72.9 72.5 70.2 75.8 77.2 85.6 -CO2 56.3 55.8 53.8 54.7 61.1 58.1 63.4 62.3 59.5 59.2 57.6 63.2 65.0 73.2 Iceland -Total GHG 3.3 3.1 3.0 3.1 3.0 3.1 3.2 3.4 3.4 3.6 3.3 3.2 3.1 3.1 -CO2 2.1 2.0 2.1 2.2 2.2 2.2 2.3 2.4 2.3 2.5 2.3 2.2 2.2 2.2 Norway -Total GHG 50.1 48.3 46.0 48.0 50.0 49.6 52.8 52.9 53.3 54.3 53.8 55.3 53.5 54.8 -CO2 34.4 33.5 33.8 35.4 37.3 37.2 40.4 40.6 40.8 41.6 41.1 42.7 41.2 43.2 Sweden -Total GHG 72.2 72.5 72.2 72.0 74.7 73.4 77.2 72.7 73.2 69.9 67.3 68.3 69.5 70.6 -CO2 56.3 56.7 56.5 56.1 58.7 57.6 61.2 56.8 57.5 54.7 52.4 53.5 54.8 56.0

Source: The Nordic countries’ 2005 National Inventory Reports to the UNFCCC, Miljøministeriet (2005), www.naturvardsverket.se

As is obvious from table 2.2, emissions vary quite a lot over the years in the Nordic countries, especially in Denmark and Finland. The differences are largely due to hydrological and climatological factors, which lead to variations in the availability of hydroelectric power in the Nordic energy system. When there is a lot of, mainly Norwegian and Swedish, hydroe-lectric power available (e.g. 2000), the need for Danish and Finnish fos-sil-fuelled power production is lower, and vice versa. In dry years (e.g. 1996) the Danish and Finnish coal condensing plants are used more in-tensively, and the electricity exported to other countries, leading to con-siderably higher GHG emissions in Denmark and Finland.

The evolvement of emissions on sector level for each country is illus-trated in figures 2.1–2.5 below. It should be noted that the sector division in the figures does not follow the sector division of the EU ETS, since there are no official statistics of the latter. However, the installations that are covered by the EU ETS are mainly to be found in the sectors ‘energy’ and ‘industrial processes’, whereas ‘transport’ for instance is not covered by the EU ETS. Compared to the EU ETS, it should also be noted that figures 2.1–2.5 show total GHG emissions, not only CO2.

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The use of emissions trading in relation to other means of reducing emissions 25

Figure 2.1 Denmark’s total GHG emissions on sector level

0 10 20 30 40 50 60 70 80 90 100 199 0 1992 1994 199 6 199 8 2000 200 2 Year M ton C O 2 e q Others Waste Agriculture Industrial processes Transport Energy

Source: Denmark’s 2005 National Inventory Report to the UNFCCC, Miljøministeriet (2005)

In Denmark, total GHG emissions show a clear “cyclical” variation over the years. As was mentioned earlier, this is mainly due to variations in energy production. The energy sector also stands for a substantial part of Denmark’s emissions.

Due to the “cyclical” variation, it is difficult to distinguish a clear long-term trend for Denmark’s total emissions. On sector level, however, the long-term trend for emissions is clearly increasing in the transport sector and clearly decreasing in the agricultural sector.

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Figure 2.2 Finland’s total GHG emissions on sector level 0 10 20 30 40 50 60 70 80 90 1990 199 2 1994 1996 199 8 2000 2002 Year M ton C O 2 e q Others Waste Agriculture Industrial processes Transport Energy

Source: Finland’s 2005 National Inventory Report to the UNFCCC

Over the years, Finland’s emissions show a similar, cyclical variation as the Danish emissions. In contrast to Denmark, however, the long term trend for Finland’s emissions is clearly increasing. Both the cyclical variation and the long-term increasing trend can mainly be explained by the emission patterns of the energy sector, which stands for a big part of Finland’s emissions.

Waste and agriculture are the Finnish sectors whose emissions most clearly show a long-term decreasing trend.

Figure 2.3 Iceland’s total GHG emissions on sector level

0 0,5 1 1,5 2 2,5 3 3,5 4 199 0 199 2 1994 199 6 199 8 2000 2002 Year M ton C O 2 e q Others Waste Agriculture Industrial processes Transport Energy

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The use of emissions trading in relation to other means of reducing emissions 27

Judging by figure 2.3, Iceland’s emissions are rather stable over the years. On the other hand, the above-mentioned effects of Decision 14/CP.7 should also be considered. Thus, additional emissions of up to 1.6 million tonnes originating from large single projects initiated after 1990 shall be reported separately and carbon dioxide emissions from them not included in national totals. This means that the de facto long term trend of Iceland’s emissions is increasing.

Figure 2.4 Norway’s total GHG emissions on sector level

0 10 20 30 40 50 60 1990 199 2 1994 1996 199 8 2000 2002 Year M ton C O 2 e q Others Waste Agriculture Industrial processes Transport Energy

Source: Norway’s 2005 National Inventory Report to the UNFCCC

Norway’s emissions show no obvious cyclical variations over the years. The long-term trend of total emissions seems, however, to be increasing, with the biggest increases coming from energy production and transport. One Norwegian sector whose emissions show a significantly decreasing long-term trend is industrial processes.

Figure 2.5 Sweden’s total GHG emissions on sector level

0 10 20 30 40 50 60 70 80 90 1990 199 2 1994 1996 199 8 2000 2002 Year M ton C O 2 e q Others Waste Agriculture Industrial processes Transport Energy

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Source: Sweden’s 2005 National Inventory Report to the UNFCCC

As figure 2.5 illustrates, due to variations in energy production, Sweden’s emissions to some extent show the same cyclical pattern as Denmark’s and Finland’s. However, in contrast to especially Finland, the long-term trend of Swedish emissions seems to be slightly decreasing.

One sector, whose emissions both make up a big part of Sweden’s total emissions and show a long term increasing trend, is the transport sector.

Relative variations

Finally, in order to round up the discussion of the Nordic countries’ his-toric and current emission levels, it should be noted that the countries’ emissions vary both in absolute and relative terms. The variation in abso-lute terms is clearly illustrated by table 2.2 and the figures above. The variation in relative terms can be illustrated by calculations of emissions in relation to the countries’ Gross Domestic Products (GDP) and per cap-ita (see table 2.3).

Table 2.3 Total GHG emissions in relation to GDP and per capita (2003 data for emis-sions and GDP, 2004 data for population)

GHG emissions in relation to GDP (tonnes CO2 equivalents per MUSD)

GHG emissions per capita (tonnes CO2 equivalents) Denmark 351 13.7 Finland 528 16.5 Iceland 295 10.7 Norway 248 11.9 Sweden 234 7.8

Source: The Nordic countries’ 2005 National Inventory Reports to the UNFCCC, Miljøministeriet (2005),

www.naturvardsverket.se (emissions), IMF’s World Economic Outlook Database, www.imf.org (GDP), www.norden.org (population)

2.3 Projected future emissions

We concluded section 2.1 by saying that the differing sizes of the gap between current emission levels and the Kyoto target indicates that the Nordic countries’ efforts to meet their Kyoto commitments in the coming years will be of varying difficulty.

The challenges the Nordic countries will meet in trying to fulfil their Kyoto commitments can also be illustrated by their projected future emis-sions. Table 2.4 shows the latest available official projections for each country. In order to facilitate a comparison with historic and current emission levels, the table is structured in a similar way as table 2.2, i.e. it shows total GHG emissions and CO2 emissions.

On general, the projections have been made as a with measures scenario.5 This means that the projections reflect the policies and policy instruments

5 In the Icelandic projection, however, the expected effects of the key measures of the climate

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The use of emissions trading in relation to other means of reducing emissions 29

that were established at the time, but do not take in to account instru-ments that will be implemented in the coming years in order to curb emissions. It should be noted that the projections therefore do not repre-sent the most probable future evolvement of emissions.

Due to the varying conditions under which the projections were made (e.g. they were made by each country individually and at different points in time), caution should be used when comparing them. For instance, the EU ETS has been taken in to consideration in the Danish, and Swedish projections, but not in the Finnish and Norwegian projections. In the case of Norway, neither has the domestic ETS.6

Table 2.4 Projections of future total GHG emissions (in million tonnes CO2

equivalents) and of CO2 emissions (in million tonnes) in the Nordic countries

1990 2003 2008–2012 Projection 2008–2012 relative to 1990 Target for 2008–2012 relative to 1990 2020 Denmark¹ -Total GHG 69.3 73.9 72.3 +4 % -21 % 67.2 - CO2 52.9 59.2 59.0 --- --- 55.2 Finland -Total GHG 70.5 85.6 80.8 +14 % 0 % 82.1 - CO2 56.3 73.2 66.8 --- --- 70.7 Iceland² -Total GHG 3.3 3.1 2.8 [3.0] -15 % +10 % 2.8 [3.1] -CO2 2.1 2.2 2.3 [2.4] --- --- 2.3 [2.4]

-CO2 emissions fulfilling

14/CP.7 0 0.4 0.4 [1.5] --- --- 0.4 [1.6] Norway -Total GHG 50.1 54.8 61.8 +23 % +1 % 68.7 -CO2 34.4 43.2 49.9 --- --- 57.0 Sweden -Total GHG 72.2 70.6 71.2 -1 % -4 % 76.3 -CO2 56.3 56.0 57.7 --- --- 63.1

Source: The Nordic countries’ 2005 National Inventory Reports to the UNFCCC, Danish Ministry of the Environment and the Danish Environmental Protection Agency (2005a), Finnish Ministry of the Environment (2006), Ministry for the Envi-ronment in Iceland (2003), Norwegian Ministry of the EnviEnvi-ronment (2006), www.naturvardsverket.se, Swedish Environ-mental Protection Agency and The Swedish Energy Agency (2004)

Notes: ¹) If the EU eventually agrees with Denmark (it will be decided in 2006) that the country’s emissions in 1990 were unusually low (due to large electricity imports from Norway and Sweden) and therefore should be adjusted, the commit-ment for 2008–2012 will be approximately 60 Mt CO2 eq, i.e. approximately -13 % relative to 1990. ²) Iceland presented

two scenarios in its third national communication under the UNFCCC. The first one assumes no additions to energy intensive industries other than the expansions already agreed upon in October 2001. The second scenario was based on the assumption that a new aluminium smelter will be built, and that both of the existing aluminium plants will be enlarged. Numbers for scenario 2 (which would lead to substantially increased emissions in line with Decision 14/CP.7) are shown in brackets.

6 It should also be noted that the Norwegian projections are based on preliminary technical

as-sumptions and should be regarded as tentative. The government will present new long-term projec-tions in 2006 (Norwegian Ministry of the Environment, 2006).

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On sector level, the projected emissions show similar patterns as those that were illustrated in figures 2.1–2.5. Thus, on general the projected future emissions from the transport sector show an increasing trend in the Nordic countries. Emissions from the energy sector are also projected to increase in the countries, albeit the emissions from the Danish energy sector are expected to decrease after 2015. That emissions from the en-ergy sector are projected to increase even in Norway and Sweden, where these kinds of emissions so far have been low, are mainly due to the pected introduction of new gas fired power plants (Norway), and the ex-pected, continued dismantling of nuclear power plants (Sweden). In Nor-way, a substantial part of the projected increase in emissions is also ex-pected to come from petroleum offshore activities.

Finally, when studying the projections, a remark from the Swedish National Allocation Plan for 2005–20077 is worth mentioning, since it might have general bearings. As was pointed out earlier, in this chapter we have chosen to describe the evolvement of emissions on sector level with a different sector division than that of the EU ETS, since there are no official statistics of the latter. However, in terms of the sector division of the EU ETS, the Swedish NAP shows that over the years there has been a “transition” in Sweden’s emissions from the non-trading sector to the trading sector, i.e. the trading sector’s share of emissions has in-creased and the non-trading sector’s share has consequently been re-duced. Thus, a transition from individual to district heating of housing and premises has been stimulated by energy and carbon dioxide taxation. The additional heat and combined heat and power production that can be foreseen is expected to entail some increase in emissions in the trading sector that partly corresponds to reductions in the non-trading sector. Furthermore, increased emissions from the refinery sector, that ensue due to requirements of other community legislative and policy instruments, are also partly balanced by relative reductions in emissions in the trans-port sector.

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3. ETS combined with other

instruments – theoretical issues

3.1 Introduction

Within environmental and energy policy in general and climate policy in particular it appears as if there is a tendency to introduce new policy in-struments without removing or adjusting the inin-struments already in use. Even if each of the measures used might be rational in themselves, there is clearly a risk that they, when analyzed together, could interact in a way that reduces the effectiveness of the overall climate policy. Given this potential risk, the effect of using multiple instruments has been given surprisingly little attention in both the academic and the policy debate. So far, analysis has mostly been focused on the effectiveness of one instru-ment at the time. The issue has however been given somewhat more at-tention lately as the need for understanding of these issues has increased with the introduction of the EU ETS. For example, research funded by the OECD and the European Commission recently analyzed the effects of emissions trading in combination with other instruments.8 Within the Nordic countries, which has a relatively long tradition in using different emissions related instruments, there is lacking assessments of how the different climate and energy policy related instruments interact.

There are several ways in which policy instruments could interact. From a general equilibrium perspective it is likely that all instruments will interact in some way or another. For example, within the literature concerning green tax reforms it has been shown that the cost of using one instrument is highly dependent on the pre-existing distortions caused by other instruments.9 In this study, however, we focus on interactions be-tween the EU ETS and (major) instruments that are aimed at mitigating greenhouse gases in the Nordic countries (e.g. CO2 tax) or a closely

re-lated target (e.g. green certificates) and/or which are connected to the use of fossil fuels (e.g. energy tax).

3.2 The effects of using multiple instruments

In general it is often stated that one should use one instrument per goal. That is, it is seldom a good idea to use e.g. carbon taxes on polluters if

8 Johnstone (2002), Sorrell (2003), Sorrell and Sijm (2003), Sijm and van Dril (2003). 9 For example, pre-existing tax distortions could through the “tax-interaction effect” increase the

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they at the same time are covered by an emissions trading system. The principal advantage of an emissions trading system is that it achieves an environmental goal, i.e. the emission cap, at the lowest cost to society automatically through the market mechanism. From a CO2 efficiency

perspective any policy that disturbs the polluters’ mitigation decision within the trading system is costly to society. The use of multiple instru-ments therefore has to be justified by other reasons. There are two main rational reasons for using additional instruments; (i) to correct for market failures and (ii) to achieve other policy objectives.

Some market failures are likely to be present although, ideally, the emissions trading system should give the participants the correct incen-tives to abate emissions, invest in carbon efficient equipment and conduct research that aims at achieving reduced emissions. However, due to ex-ternal effects, the incentives to reach the optimal amount of investment and research may not be given by the price of emission allowances. For example, early investment in carbon efficient technology might be bene-ficial to society if investment and use of the technology is characterised by e.g. knowledge spillovers leading to social rates of return to R&D in excess of the private rates of return.10

Other policy objectives such as raising public revenues, mitigating “secondary emissions” from fossil fuels consumption, and income distri-butional issues could also motivate the use of multiple instruments.

3.2.1 Emissions trading and emission taxes Using an emission tax as a “safety valve”

In theory, the choice between quantity regulating instruments such as an ETS with an emissions cap, and a price regulating instrument such as an emission tax, does not matter given that the cost and benefits are known with certainty. By using any of these instruments, the policymaker can reach the optimal emission level at the same cost. If there is uncertainty involved, however, the instrument choice matters. Weitzman (1974) showed that this instrument choice depends on the relative slope of the marginal cost and marginal benefits curves of abatement. In general, if there is uncertainty of the marginal cost of emission reductions, while at the same time the marginal benefit curve is known to be relatively flat, then it is optimal to use a price regulating instrument. This result is due to the fact that with a flat marginal benefit curve the cost of misjudging the effect of the price regulating instrument is small. If the emission target is fixed by a quantity regulating instrument, on the other hand, the cost of misjudging the position of the cost curve might be substantial if the mar-ginal abatement cost is increasing steeply.

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The use of emissions trading in relation to other means of reducing emissions 33

Based on this observation Roberts and Spence (1976) showed that there are situations when a combination of a trading system and an envi-ronmental tax instrument is preferable to a single instrument. For this to hold, it is required that the cost of abatement is uncertain and that the environmental damage curve is non-linear, i.e. two conditions that applies to many environmental problems. By using emissions trading and an emission tax that put an upper bound on the price of allowances, the wel-fare cost from misjudging the marginal abatement cost can be reduced. Such a combination of instruments is often referred to as an ETS with a so-called safety valve, e.g. an ETS with a fixed per unit penalty for non-compliance, which in principle is a combination of emissions trading and an emission tax.11

Although an ETS with a safety valve feature is preferable in many situations it has the drawback that it does not guarantee that the emission target is reached. Including a safety valve feature in the EU ETS could result in a substantial burden for the non-trading sectors due to the fixed cap put on the EU by the Kyoto agreement. That is, if the safety valve is used any emission increase in the trading sector would need to be “cor-rected” by an increased use of measures in the non-trading part of the economy. To be effective, the safety valve price cap should apply to both the trading and non-trading sectors, but this is obviously not possible because this could result in non-compliance with the absolute emissions target.

EU ETS and CO2 taxation

As described above, a combination of emissions trading and taxes could be preferred in some situations. However, in optimum the two instru-ments are never used simultaneously, i.e. only one instrument is applied at any point in time. Within the EU ETS some Member States use a CO2

tax or charge which at least partly is levied on the sectors covered by the trading system. Nevertheless, by taxing CO2 emissions that are included

in the ETS there is no gain in effectiveness within the system due to the emissions cap. In fact, it is quite possible that the effect will be the oppo-site, i.e. lower economic effectiveness, which is illustrated in the follow-ing example.

If all Member States taxed emissions at a common tax rate this would result in a decrease in the price of allowances and also set a lower bound for the price of emitting CO2 (when the price of allowances reaches zero).

This is illustrated in the box diagram in figure 3.1, which consists of two merged “abatement cost diagrams” for country A and country B with marginal abatement cost represented by MACA and MACB,

11 See e.g. Ellerman and Jacoby (2002) and Pizer (2003) for a discussion on ETS with a safety

valve. It should be noted that the EU ETS does not include this safety valve feature because in addi-tion to the 40 Euro penalty (in the first trading period) the non-complying installaaddi-tion is required to hand in the missing allowances, i.e. the penalty does not cap the price.

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12

tively. If these two countries together start up an ETS with an emission cap corresponding to the base of the box, the allowance price would be PETS and the emission levels would be eAETS and eBETS for country A and

B, respectively. If both countries tax emissions with the tax t < PETS the

outcome of the ETS will not be affected. The result will only be that the price of permits decrease to PETS – t. That is, the price of allowances will

decrease with an amount corresponding to the tax rate. However, if the tax exceeds PETS, higher abatement levels will result in total emissions

that are lower than the emission cap and the price of allowances will be zero.

Figure 3.1 Emissions trading with emission tax

PA

I the case where the emission tax levels differ, e.g. if an emission tax is applied unilaterally by only one country, the tax might undermine the primary aim of the ETS which is to achieve a given emission target at least cost. This is realised by starting from a situation where the ETS is used without CO2 tax. In figure 3.1 that would correspond to a situation

with an allowance price of PETS and emission levels of eAETS and eBETS for

country A and B respectively. If country A, in this situation, introduces a tax on CO2 emissions the allowance price will not adjust fully as in the

case where both countries introduced the tax. Instead the tax will increase the marginal cost in country A, which will reduce the emissions in that country. This in turn will result in more allowances available for country B, and reduce the price of allowances somewhat until a new equilibrium

12 In the box diagram country B’s “cost of abatement diagram” has been turned upside down on

top of country A’s “cost of abatement diagram”. The side of the box (the x-axes) exactly matches the assumed emission cap for both countries together, i.e. the cap for the emissions trading system.

MACA A e A t MACB eB eB0 eBETS t B PETS PB PETS eAETS eA0

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The use of emissions trading in relation to other means of reducing emissions 35

is reached. In this equilibrium country A will emit less than in the situa-tion without the tax and pay a price that is higher than PETS. Country B,

on the other hand will emit more than before and pay a price that is less than PETS. Thus, the abatement cost on the margin will differ between

countries but the emission level will be unchanged, i.e. a situation that clearly differs from the optimality condition with equal abatement cost at the margin in all countries.

3.2.2 Emissions trading, subsidies, green certificates and regulations

There are currently a number of subsidies used to promote the use of climate friendly technology or renewable fuels within the Nordic coun-tries..13 The subsidy could be levied on investment in a certain technol-ogy or directly on the price of using renewable fuels or on climate related R&D. The subsidy could also be given by issuing renewable electricity (green) certificates together with a renewable electricity quota obligation on electricity users. The potential for interaction between the ETS and these kinds of instruments differs depending on what type of subsidy that is considered. As pointed out by e.g. Johnstone (2002), a subsidy on in-puts related to abatement of greenhouse gases (e.g. subsidies on renew-able energy inputs) will shift the marginal and average abatement cost curve down. An investment subsidy, on the other hand will shift the aver-age abatement curve down but leave the short-run marginal abatement curve unchanged. This imply that the investment subsidy will not in any major way affect the allowance price in the short run, but through effects on the timing and the scale of investments it will affect the trading system in the longer run.

Subsidies on the use of renewable energy sources

There is a clear connection between the use of tradable CO2 allowances

and the profitability of renewable energy sources – higher allowance price will make renewables relatively more attractive. In the case with subsidies on the use of renewable fuels, the effect would be similar to the use of a carbon dioxide tax. That is, the subsidy will change the relative price of fossil fuels and renewable fuels and therefore make fossil fuels less attractive. However, contrary to the use of a carbon dioxide tax the subsidy does not stimulate abatement through other means than substitut-ing toward the use of renewables. Given that a well functionsubstitut-ing ETS will attain the emission target at least cost, a subsidy on the input of renew-ables will clearly distort the market and therefore be inefficient. Thus, using government funds to provide an “additional” advantage subsidy must be justified on other grounds than attaining climate related targets at the least cost to society.

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Subsidies on investment and R&D

Ideally, the ETS should give the correct incentive to invest in energy efficient and renewable energy technology by making such technologies more profitable. The use of investment and R&D subsidies on carbon efficient technologies in addition to an ETS could clearly disturb the market and thereby increase the overall cost of reaching the emission reduction target. However, as was pointed out earlier, it may be rational to subsidize investments and R&D. This is the case if it is believed that there are external effects from these activities that would make social rates of return to investment and R&D in excess of the private rates of return created by the emissions trading system. Such increase social rates of return could for instance come from of “learning-by-doing” effects and knowledge spillovers.

Green certificates

A green (renewable energy) certificate system is in many ways similar to direct subsidies to renewable energy use but with the important difference that the certificate system is financed within the energy sector and that it guarantees that a certain amount of renewable energy will be used. In some countries green certificates are used in parallel with CO2 emissions

trading. The two systems do not imply that two instruments are used to reach the same target. The renewable energy target may, at least partly, be established on other grounds than mitigating climate impact, such as security of supply through using domestically produced fuels. However, as the goals are interconnected the price on the CO2 market will affect the

price of green certificates.

If the CO2 allowance price is high enough for renewable energy

pro-duction to become an attractive alternative to fossil fuels, the use of re-newables may be higher than the required quota obligation set within the green certificate system. In this case the price of green certificates will fall to zero and there will be no impact on the emissions trading system. If the price of CO2 allowances stays below the level that induce the

suffi-cient use of renewables, then the green certificate price will be positive and will therefore disturb the CO2 market and bring on an inefficiently

high use of renewables from a CO2 mitigation perspective. Thus, the

“in-efficiency” must be justified by other reasons than reduction of CO2

emissions, such as e.g. security of supply.

Regulations

In general regulations that focus on carbon dioxide emissions are incom-patible with emissions trading. The reasoning is analogous to what has been described above. By putting further binding restrictions on emis-sions trading sectors the outcome is likely to be non-optimal from a car-bon efficiency perspective. For example, by regulating (some) emissions trading industries to use the “best available technology” with respect to

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The use of emissions trading in relation to other means of reducing emissions 37

CO2 emissions, it is likely that too costly emission reduction will take

place in the industry. The result will be a disturbed market with a subop-timal increase in emissions elsewhere within the trading system, equiva-lent to the effects in the CO2 tax example discussed above.

3.3 Conclusions

In this chapter, we have briefly discussed some theoretical issues con-cerning the use of emissions trading in combination with other instru-ments, particularly the effects of using multiple instruments. In order to summarize the discussion, we would especially like to emphasize the following:

The theory clearly indicates that an ETS in many instances is an effi-cient instrument. There are nevertheless situations where price regulation instruments, such as an emission tax or an ETS with a price cap, are pref-erable. However, when the emission target level has to be attained due to e.g. binding agreements, a pure cap-an-trade system is likely to achieve the goal in an efficient manner.

In general, the use of tax and/or subsidies on emissions and sectors covered by the ETS, with the purpose of contributing to emission reduc-tions is not recommended. At best, when policies are internationally co-ordinated, the instruments will have no effect on effectiveness. If the instruments are applied unilaterally in an uncoordinated manner, the re-sult will most likely be a reduced environmental effectiveness. Any in-struments used on the trading sectors, e.g. fossil fuel related taxes or sub-sidies to renewable fuel use, has to be motivated by some other goal than emission reductions. These other kinds of goals could for instance be revenue raising, security of energy supply or for equity reasons.

Given that the EU ETS is in place and functioning properly it appears to be appropriate for policy makers to review their use of other instru-ments. The loss of environmental effectiveness from using ETS alongside other instruments should be compared with the additional benefits these instruments might have. This may be particularly important for the Nor-dic countries which have many other CO2 related instruments in place.

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